Petards in Central Banking

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Last week, the price of oil hit $127 a barrel. Oil imports to the United States cost 67% more this year than last. Imports other than oil rose more than 6% — or three times the Fed’s key lending rate. Steel has shot up too — almost 50% in the last 12 months. And gold rose a full $19 on Friday…it’s practically back at $900.

Naturally, the papers are squawking about inflation today. The Financial Times worries that inflation is going to undermine pensions and retirement plans. The International Herald Tribune, meanwhile, says inflation is undermining central banks’ efforts to…well…cause inflation!

Wait — we know what you’re thinking. Something is very wrong with a world where central banks cannot cause inflation any time they want to. Next, they’ll be telling us that you can’t have a cigarette when you want one…

But the papers are full of remarkable things…so why not? Besides, there are so many petards in central banking anyway; Bernanke and company were bound to get hoisted on one of them.

A society has no more real savings (resources set aside) than it actually has. And it sets interest rates (the price of those savings) as it sets any other price — on the basis of supply and demand. When the Fed intervenes with artificially low rates, it is merely pretending that it has resources available that it does not actually have. That is the trick known popularly as "inflation," in which the supply of purchasing power is inflated with money that doesn’t exist.

Since the beginning of the credit crisis last summer, Fed policy has been purely inflationary — intended to convince people that they had more money and credit than they thought…and that they should spend it and invest it. But that policy can’t work forever. Eventually, consumer prices rise sharply. Then, the game is over…the Fed has to "lower inflation expectations" before it can inflate again. The hocus pocus only has a positive effect, in other words, as long as people are misled…once they catch on, the jig is up.

And here we beg readers’ attention of a moment of deeper thought. This classical, cynical view of inflation seemed to be wrong for so long people began to think it was wrong forever. An entire generation has grown up with 1) a dollar with no connection to gold, 2) a dollar that actually rose against gold for 20 years, 3) Wal-Mart’s Every Day Low Prices, 4) apparently inexhaustible supply of cheap labor 5) globalized markets and supply chains and 6) falling bond yields. No wonder people began to think that inflation was no problem…and never again would be. Central bankers claimed they could now control economic cycles so as to have growth without inflation…boom without bust…forever. But forever seems to have come to an end already.

"The specter of inflation has risen over financial markets…" begins the IHT story.

Central banks can only get away with making money easier to get when consumer prices are under control. When prices for gasoline, milk and margarine begin to rise, people get fussy. They want their central banks to stabilize prices. And central bankers themselves look at their lending rates and get a little embarrassed. "How come you’re lending money so cheap?" economists ask them.

The fear is that if inflation is allowed to get "out of control," it takes harsh policies to bring it back in line. Harsh policies are what everyone wants to avoid…especially before an election.

Classical economics tells us that an asset price bubble is always followed by an asset price bust. Inflation is followed by deflation, in other words.

But in our funny, complicated world, we get both inflation and deflation at the same time. The last two big bubbles — in residential housing and the financial industry — are deflating. Prices are going down for both assets. But inflation-sensitive commodities, most notably oil and gold, have soared. And now prices seem be working their way up all along the chain…from the oil wells, to the shipping containers, to the Chinese sweatshops, to the shelves of Wal-Mart. A photo in today’s paper, for example, shows a pump at a filling station in New York with diesel fuel over $5.

What this means to central bankers is that they have to watch it. They can’t cut rates so freely…not while consumer prices are rising. Instead, the pressure will be on the other side — to raise rates.

To the man on the street it means that he has to prepare to pay higher prices for everything.

And to investors? What does it mean? It means inflation will do the work the bear market hasn’t been willing to do — that it will reduce the real value of stocks and bonds, even if nominal prices remain steady. Tim Bond, of Barclay’s Capital says, "investors have to be prepared for a few very unpleasant years. Bonds of all types — aside from index-linked — have no place in portfolios at current yields. Equity exposure should be narrowed to resources, energy, industrial goods and services — and once the write offs are completed — financials."

u2022 Being the world’s leading hegemon is mostly thankless. You have to maintain military garrisons all over the world and try to keep the barbarians under control — which is so expensive you are almost guaranteed to go broke. And when a competitor challenges you, you have to meet the challenge. Cartago delenda est (Carthage must be destroyed), as Cato put it.

The only benefit of empire is also a curse: you get to tell others what they should do. Thus did the U.S. president lecture the Mideast yesterday, says today’s paper. Unfortunately, your earnest attempts at world improvement are seen by others as nothing more than hollow vanity. "You want to be a winner," you say to the wogs and wallywallies, "then be like me."

Everyone wants a little edge…a little extra grandeur…the feeling of superiority that comes from being among the elite. (There is also the hope of catching a few crumbs as they fall from the grand table.) So, typically, subject peoples try to sidle up to imperial race…and imitate their speech, dress, and manners. During the Roman era, for example, the local people of Londinium wore togas, spoke Latin, gave their children Roman names, worshipped Roman gods and angled for jobs and gratuities from their Roman masters. Later, the British Empire brought out the same fawning sycophancies. Even though the English tried to keep their culture to themselves, it was not uncommon to see a freed slave in Jamaica or an uppity native in far Mandalay speaking English and wearing a waistcoat.

We are reading a book about an English slave trader on the Gold Coast in the 18th century. The man thought he was doing the Africans a favor by selling them into slavery in North America. First, because their prospects on the Dark Continent were so grim…and second because — as he saw it — the benefits of Christianity and Western civilization were so bright. Captain William Snelgrave provided an illustration to prove his first point. He went to visit a local chief (presumably to buy slaves). There, he saw a small child tied to stake, in miserable condition. When he asked what was going on, he was told that the child was to be sacrificed (and eaten) in order to appease the tribes’ gods. The captain promptly told the chief that his God would not permit such a thing. After some tense negotiation, Captain Snelgrave was able to buy the child and restore him to his mother. (The storyteller is not explicit about what happened to them later; we have to use our imagination. They were probably both sold to a cotton planter in Louisiana. Today, their descendants may be spread all over the United States of America, rigging local elections in Baton Rouge, studying marketing in Boston, and struggling to keep up with sub-prime adjustments in Modesto.)

Today, the U.S.A. is in the number one position. Whatever the cost, Americans have bragging rights to the imperial position…and the right to tell others what to do.

The president of all the Americans — George W. Bush — took full advantage of this privilege yesterday. According to the IHT, while making a speech in Egypt, he "presented Arabs with a lengthy to-do list." Of course, the list came not from any particularly deep or novel reflection on his part. Instead, he merely urged them to be more like George W. Bush.

Democracy is a key to peace, said the U.S. President, offering no evidence. He added that economies couldn’t flourish unless opportunities were offered to women, perhaps forgetting the first hundred years of the Industrial Revolution.

Meanwhile, the U.S. Army apologized for using the Koran for target practice.

u2022 Uh oh…and what’s this?

"Global food supplies at risk," says a headline in the IHT. "The brown plant hopper, an insect no bigger than a gnat, is multiplying by the billions and chewing through rice paddies of Southeast Asia."

u2022 Jules came back from Los Angeles last week, where he was working as an intern as part of a university film program.

"What do you think…are you going to work in Hollywood?" we asked.

"I don’t think it’s for me… It’s a strange business…and a strange world. And there are so many different things going on that it is hard to generalize. I was reading scripts. But only some scripts. If we got a script in the mail, from someone we didn’t know, we weren’t allowed to read it. We couldn’t open it. Because, the studio is afraid that it will be charged with stealing someone’s idea. So we send them back unopened.

"But when we got one from an agent…or someone they know…then, they’d give it to us to read. If we rejected it, they’d throw it away. But if we weren’t sure, they’d take a look themselves. Almost always they were terrible…just one stupid cliché after another. They all come from struggling screenwriters. All young. All with the same ideas, more or less. And all with the same awful writing.

"But the real trouble — and why I don’t think I’m cut out for a career in Hollywood, at least not as a screenwriter — was that I realized that my own writing was just as bad as theirs. I’m just like they are."

Bill Bonner [send him mail] is the author, with Addison Wiggin, of Financial Reckoning Day: Surviving the Soft Depression of The 21st Century and Empire of Debt: The Rise Of An Epic Financial Crisis and the co-author with Lila Rajiva of Mobs, Messiahs and Markets (Wiley, 2007).

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